Many investors think stockpicking is a numbers game, primarily a matter of analysing a company's fundamentals. But in doing so they are missing a trick – or so says Jeremy Lang, co-founder of and portfolio manager at Ardevora Asset Management.
"We see what we do as fundamentally a game about psychology – it's a two-directional thing," says Mr Lang. "It's partly about trying to spot the kind of situations where it is understandable that other investors could be more error prone and biased."
So as well as looking at the fundamental case for investing in a company, he and his colleagues apply cognitive psychology methods to stockpicking. They do this by paying attention to the behaviour of three groups: company managers, financial analysts and investors.
"We watch the behaviour of these people for signs of bias," explains Mr Lang. "With management, we look for indications of hubris, denial and excessive risk taking. With analysts, we look for signs of overconfidence, blinkering and belief in a good sounding story. And with investors we look for signs of excessive anxiety or overexuberance, and a fixation on recent emotive events."
He avoids meeting company managers, preferring to judge them on observable facts such as stock prices, valuations, forecasts and company accounts.
"I spend a lot of time reading what they say and picking through their choice of words when they answer others' questions, to basically work out whether they are trying to mislead or not," he says. "And if I think they are trying to mislead, then I think they are probably trying to hide something, which probably means [the company] is risky and I don't want to be anywhere near [it]. But if they are relaxed, open and quite honest, then I think I can probably trust them, for now."
As well as recognising and exploiting the mistakes other investors can make, Mr Lang also tries to keep his own cognitive biases in check via his sell discipline. He reviews all the stocks in the funds he runs every three months and cuts those he believes are not working out.
As a result, his funds tend to have a high turnover, which increases trading costs. Ardevora UK Equity (IE00B3WN9227), for example, has a portfolio turnover rate of 57 per cent. But he argues that knowing when you have made a mistake and selling quickly is an important skill, as too often investors get personally attached to their buying decisions and continue to hold on to a poorly performing stock.
"The way you view something when you're thinking about buying it is quite different to the way you think once you've bought it," he explains. "You basically look at different information. It's quite easy to be seduced into buying something because you build a view that makes you want to be convinced of why you should buy it, and you see it as an opportunity. But once you get in, suddenly you can see all the risks."
One way Mr Lang corrects his own purchasing errors is to sell the stock in question and then short it – bet on its share price falling. Ardevora funds that can short stocks include Ardevora UK Equity, which typically has a long/short ratio of 150/50. Its long positions are about 150 per cent of its net asset value (NAV) and its short positions about 50 per cent.
Over three and five years this fund is in the top quartile of the Investment Association UK All Companies sector in terms of performance. By contrast, Ardevora UK Income Fund (IE00B4MKXW82), which has the same long positions but does not short stocks, has not made such strong returns.
Although both funds have the same long positions, Ardevora UK Equity has roughly equal weightings across all the stocks it holds, whereas Ardevora UK Income has larger weightings in stocks with higher yields.
Mr Lang is sanguine about the outlook for UK markets despite the uncertainty surrounding the UK's withdrawal from the European Union.
"There's a UK recession coming, but it won't have that much impact on the market, which is dominated by large multinational businesses," he explains. "It's slightly befuddling because you feel as though the UK market ought to be responsive to things such as Brexit and a recession, but actually they don't matter."
However, there are other challenges, such as digital disruption to areas such as traditional print media, advertising and retail, which has much further to run.
"Because of the history of the UK economy, we've got quite a lot of those types of businesses," says Mr Lang. "It's getting even tougher for these sunset industries and it's got nothing to do with the economy – just the juggernaut of Facebook (FB:NSQ), Google (GOOGL:NSQ) and digital media."
Companies such as ITV (ITV), Daily Mail and General Trust (DMGT), and WPP (WPP) look vulnerable. But Mr Lang thinks there are also some opportunities, for example online retailer Asos (ASC).
He is also finding opportunities among high-quality, internationally focused businesses operating in specialist areas. These include Rotork (ROR), which designs and manufactures electric, pneumatic and hydraulic valve actuators, and Victrex (VCT), a supplier of polymer solutions.
"These businesses have been around for a reasonably long time, but have remained quite focused and good at what they do, which means they've been able to carve out an expertise they can export around the world," says Mr Lang. "Despite the doom and gloom about the death of the manufacturing industry, there are actually some quite nice businesses around."
